Sunday, May 16, 2010

Greek debt crisis caused by foreign banks

First Greece hires banks to help it hide debt, then, when it is caught, it threatens to sue its enablers. Only in Greece can a drunk sue his bartender. 

From the AP:
In Athens, Greek Prime Minister George Papandreou said he is not ruling out taking legal action against U.S. investment banks for their role in creating the spiraling Greek debt crisis.
"I wouldn't rule out" going after the U.S. banks, he said in a CNN interview aired Sunday.

They also blame bank economists for telling the truth about Greek default risk:

The government and many Greeks have blamed international banks for fanning the flames of the debt crisis with comments about Greece's likely default.

Wednesday, May 12, 2010

The new government in Westminster

Well, I am relieved that Nick Clegg and the LibDems could not make a deal with Labour and have instead agreed to form a coalition with David Cameron and the Tories. This is good news for Britain, but probably bad news for the Tories. 

They have inherited a government with falling revenue, rising expenses and a high debt load. They are going to have to bring the deficit back into the low single digits in order to stabilize the debt-to-GDP ratio. Given the presence of the LibDems in the government (and possibly at the Treasury), this will be accomplished by raising taxes as well as expense control. It's hard to see how this will make the government popular. 

The UK's principal problem is its overdependence on the City of London (the financial services industry), which is shrinking in size due to the 2008 panic and subsequent woes. Financial reform may be necessary, but killing the City is killing the egg-laying goose. 

We will learn more this week about the cabinet and policies of the new government.

Monday, May 10, 2010

Framing the Greek problem

From Thaler's Corner on Seeking Alpha three days ago:

Let's not kid ourselves. The European Monetary Zone is on the brink of implosion, along with the European Union, the Schengen area and everything else that goes with it.
The situation on eurozone peripheral nation debt markets is grim.
Investors who must sell debt instruments as a result of credit agency downgrades are not finding any buyers.
Aside from any Austro-liquidationist monetary theory, if we are to maintain the "E" in ECB, the latter must absolutely launch a massive and transparent European government bond purchse programme (Shock and Awe).
The state bureaucrats presently sitting on the ECB Governors Council will never dare to approve such a solution without firm orders from their government leaders.
Sarkozy and Merkel are meeting today in Brussels and have summoned Mr. Trichet to attend.
No European leader should want to be stuck with the sort of historical stain left by Andrew Mellon, US Treasury Secretary from 1921 to 1932 :
  • ‘Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate’.
  • ‘It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life.’
  • ‘Values will be adjusted, and enterprising people will pick up the wrecks from less competent people’.
We will see soon enough.
Best of luck to everyone.

The UK: A coalition of evil

Wow. The UK is really heading up a fetid creek without a paddle. 

We are looking at a (likely) Lib-Lab coalition government with an unpopular and lame-duck PM. Could this be any worse? Yes it can. 

First of all, a Lib-Lab coalition is still short of a majority, so they would have to make unholy deals with the Scottish and Welsh national parties, which are very left and have their hands out for tips. Their condition for signing on is "funding guarantees" for their dependent regions--at a time when the government's top priority must be fiscal consolidation. 

But wait, there's more. Because Brown has said that he will step down as leader of the Labour Party, that means that the next PM will have to be elected by Labour's electoral college. The  Labour electoral college is made up of three parts, each carrying equal weight: lawmakers, labor unions and party members. 

So in the midst of a fiscal crisis, we are looking at a government including an enormous amount of regional and left-wing baggage, and a PM chosen by the labor unions. This means higher taxes and more socialism at a time that the country is staring into a fiscal abyss.

And, as part of the Lib-Lab deal, Labour has agreed to change the 300-hundred year old electoral system from single-member constituencies to proportional representation. The represents the Italianization (or Israelization) of the UK. 

We can look forward to unending government "crises" every time that some obscure party leaves the government. The government will be hostage to its smallest coalition partners (like Likud's dependence on ultra-right wing religious parties). 

Oh, and another thing: bringing in SNP and Plaid Cymru is a UK suicide pact. The closer the UK gets to regional autonomy subsidized by English taxpayers, the closer England will get to demanding its own devolution. It's only a matter of time until England demands equal rights and elects its own parliament, which is the beginning of the end of the United Kingdom.

What a mess. Looks bad for sterling, FTSE, and above all, gilts.

Europe blinks

The EU stared apocalypse in the face yesterday...and blinked. This weekend's summit represents policy turnarounds on three major issues.

One, the ECB has agreed (undoubtedly under pressure) to monetize government debt (by buying in the secondary market, but it has nonetheless lost its virginity). Such a policy was not contemplated when the ECB was established. 

This is a hugely positive step, because it represents a capitulation by the no-bailout hawks to the save-the eurozone doves. (Note that this does not represent a change in monetary policy, because the ECB will sterilize any such purchases.)  Because the ECB has unlimited resources in euros (because it prints them), it represents a highly credible source of stabilization.

Two, the eurozone has transformed itself from a currency union into a federal state, with the creation of an EMF guaranteed by EZ members on a pro rata basis. The size of the fund (EUR 500B) is sufficient to be credible, if consummated.

Three, the EU has made the IMF a full partner by inducing it to offer a backstop of EUR 250B, and thus letting it into the zone and giving it power to impose conditionality, as it is already doing with Greece. 

Will this work? Right now we're looking at a PowerPoint presentation rather than a treaty; there are many blanks to be filled in and many i's to dot and t's to cross. 

Some questions:

1. Will all member states agree (non-ez states must agree to release the EU contingency fund)? Will this fly with the German Constitutional Court?

2. The plan is for the EMF to issue bonds guaranteed on a pro rata basis, not on a joint and several basis. These bonds will be difficult to rate. You have an underlying credit that looks pretty bad, and then guarantees from countries with different ratings. Doesn't look AAA to me. Or will the ECB buy them without ratings?

3. Greece looks like a bad credit. If it defaults, will Ireland, Portugal and Spain have to pay up? What if they don't, or can't?

4. What happens when Greece misses its fiscal targets, as it will?

I think that this rescue will successfully postpone an explosion, but will not result in a permanent solution. 

Instead of allowing Greece to escape the eurozone and devalue its way out of its problems, this scheme will instead allow Greece to add further to its debt burden, making it increasingly insolvent, while degrading the creditworthiness of its creditors. 

Friday, May 7, 2010

Trichet is going to bankrupt the Eurozone

Europe has a choice: the ECB buys government (i.e., Greek) bonds, or, alternatively, allows the hopeless states to get off the train and return to monetary sovereignty. The problem is  this: Greece will, not get off the train and will choose default, which means that the other  PIIGS are facing the apocolypse. Buy canned goods,  decorate  your bomb shelter,  and get out of euros.

Trichet suggests action on bonds would be last resort

THE EUROPEAN Central Bank is under growing pressure to take fresh action to stem a widening crisis of confidence in euro zone government debt, though it remains likely for now to stop short of buying bonds.

Markets punished the euro and bonds on the weak periphery of the zone after ECB president Jean-Claude Trichet said central bankers did not even discuss at its Thursday meeting what analysts have dubbed “the nuclear option”. Market conditions may not so far be bad enough to convince the ECB to take that controversial step.

Instead, the ECB’s next steps could include reinstating 12-month loans for banks at fixed interest rates, lending US dollars again, or announcing a blanket waiver of its collateral rules for all euro zone sovereign debt in money market operations.

“Market expectations certainly are that the ECB will do something, that the governments would take too long to do something or they are not willing, not able,” said Fortis economist Nick Kounis. “Therefore the ECB, which has more flexibility, should jump into that vacuum.”
The difficulty which euro zone governments had in negotiating their €110 billion bailout of Greece suggests they cannot be counted upon to agree on fast, concerted action to prevent credit jitters from spreading through global markets. That may leave the ECB as the only European institution with the ability to intervene effectively in the widening crisis.

Mr Trichet will meet other top central bankers at the Bank for International Settlements (BIS) in Basel this weekend, an excellent opportunity to discuss any co-ordinated liquidity action.

There is a precedent: central bankers from Europe and North America agreed in principle on joint liquidity injections at the November 2007 BIS meeting, and actually conducted those injections a month later.

European central banks have let currency swap lines with the US Federal Reserve lapse, but these could be restarted at any time.
The ECB held a conference call with commercial banks yesterday to gauge the state of money markets.

“It is a possibility for the US Fed and the ECB to do this specific market measure in just a few hours because it is just reinstalling something that was there before,” said one money market desk head who participated in the call.

Economists said the ECB would likely hold the option of buying bonds in reserve until it had exhausted more conventional ways of flooding markets with cash.

“They are most likely to do if there is a further panic on the market and we see a further increase in the LIBOR/OIS spreads and interbank confidence for lending does subside – then I think the ECB will be the only institution that will try and calm markets down,” said Kenneth Broux from Lloyds TSB.

Many say that anything short of government bond purchases may fail to calm the markets.

EU rules prohibit the ECB from buying government bonds from the primary market, but this would not be a show-stopper.

“You have this ‘no monetary financing’, but you are allowed to buy in the secondary market, so what’s the difference?” an official involved in European banking supervision told Reuters. “Buying in the secondary market, you take the pressure, and so you push people in the primary market.”

Analysts have estimated the ECB might buy some €200 to €300 billion of bonds, about 20 to 30 per cent of estimated annual new issuance in the euro zone.

Its covered bond programme was comparatively larger, comprising about 60 per cent of new issues at the time. But some analysts say the ECB would sacrifice credibility as an inflation fighter if it bought government bonds, potentially affecting inflation expectations.
This probably explains Mr Trichet’s uncompromising tone on Thursday.

Socialist logic

So let me get this straight: Congress proposes anti-Wall Street legislation, the stock market falls by hundreds of points, and that shows that we need more anti-market legislation. Welcome to 1934.

Senators say volatility makes case for regulation

US senators advocating stricter limits on banks and tougher regulation of markets used Thursday’s volatility to demand more sweeping reforms as the financial regulatory bill edged towards a vote.

Ted Kaufman, the Democratic senator from Delaware, said the sell-off in the S&P 500 supported his case that high-speed trading needed more regulation and banks needed more limits on their activities and size.

He told the Financial Times that he would try to introduce a proposal requiring the Securities and Exchange Commission to report on high frequency trading “much sooner” than they were due to.
“Until today,” he said, he was struggling to get traction on the issue with other senators.

In addition to new proposals directly aimed at high-frequency trading, Mr Kaufman said Congress should support his amendment to put size caps on deposit-taking banks. “Banks should not be involved in high-risk/high-return proposals . . . There’s a potential for a meltdown and [then] you’ve got a commercial bank in the crosshairs.”

Mr Kaufman’s pet cause appeared to be gathering ground in Congress as the market panic filtered through to the Senate floor. “I have become a believer,” said Mark Warner, a Democrat from Virginia. “Everything in my gut says he’s on to something here.

“I think there was a warning sign shot across the bow today,” Mr Warner added. “As we deal with financial re-regulation, if we don’t make sure this is part of the mix, I think we’re not acting appropriately.” The market moves overshadowed a series of amendments, including a failed Republican move to loosen the power of a proposed Consumer Financial Protection Bureau and a bipartisan effort to introduce a sweeping audit of the Federal Reserve.

A frantic mobilisation of Fed officials helped modify the audit amendment, which was proposed by Bernie Sanders, the independent senator from Vermont. Eventually, in an attempt to secure passage Mr Sanders agreed to keep a ring-fence around monetary policy, shielding it from congressional audits.

A vote on the amendment, which was one of several areas of regulatory reform that has concerned the Fed, was held up last night as Democrats struggled to corral their members on the Senate floor.

Earlier senators approved an amendment that would force bigger banks such as Citigroup to pay more to insure deposits, while cutting the cost for smaller institutions.

A host of other proposed changes, ranging from capping interest rates on credit cards to reintroducing the prohibition on commercial banks owning an investment bank, will be considered in the next few days.

Judd Gregg, the Republican senator from New Hampshire, predicted that the bill was now certain to pass but he hoped to make changes, including removing a provision that would force banks to spin off their derivatives trading desks.

The Democrats hope that a final vote can take place next week but Republicans warned that they intended to take as much time as they needed to consider hundreds of amendments, potentially prolonging the process.

The UK election disaster

The election results are bad news for the UK, its bonds (gilts), and its currency. The LiDems emerge as the kingmaker, and their demand is proportional representation, which would be a constitutional disaster for the UK. 

Although the two party system has its drawbacks, such as the perpetual need for intraparty consensus and thus maddening vagueness. But if you look at countries that have proportional representation, you will see no party with a majority and the need to form awkward coalitions with greens, fascists, vegans and religious extremists. 

The UK is looking at the biggest fiscal challenge since 1945. Because (like New York) the UK lives off of the securities industry, government revenue is collapsing and the fiscal deficit is an out-of-control 13% of GDP. 

This no time to change the UK constitution in a way that will lead to legislative chaos. This could lead to a loss of confidence in gilts and sterling. 

(But maybe good news for the US; as investors flee Europe, the US will enjoy strong capital inflows and declining Treasury yields.)

Krugman lays out the Greek endgame

May 7, 2010

A Money Too Far

So, is Greece the next Lehman? No. It isn’t either big enough or interconnected enough to cause global financial markets to freeze up the way they did in 2008. Whatever caused that brief 1,000-point swoon in the Dow, it wasn’t justified by actual events in Europe.

Nor should you take seriously analysts claiming that we’re seeing the start of a run on all government debt. U.S. borrowing costs actually plunged on Thursday to their lowest level in months. And while worriers warned that Britain could be the next Greece, British rates also fell slightly.

That’s the good news. The bad news is that Greece’s problems are deeper than Europe’s leaders are willing to acknowledge, even now — and they’re shared, to a lesser degree, by other European countries. Many observers now expect the Greek tragedy to end in default; I’m increasingly convinced that they’re too optimistic, that default will be accompanied or followed by departure from the euro.

In some ways, this is a chronicle of a crisis foretold. I remember quipping, back when the Maastricht Treaty setting Europe on the path to the euro was signed, that they chose the wrong Dutch city for the ceremony. It should have taken place in Arnhem, the site of World War II’s infamous “bridge too far,” where an overly ambitious Allied battle plan ended in disaster.

The problem, as obvious in prospect as it is now, is that Europe lacks some of the key attributes of a successful currency area. Above all, it lacks a central government.

Consider the often-made comparison between Greece and the state of California. Both are in deep fiscal trouble, both have a history of fiscal irresponsibility. And the political deadlock in California is, if anything, worse — after all, despite the demonstrations, Greece’s Parliament has, in fact, approved harsh austerity measures.

But California’s fiscal woes just don’t matter as much, even to its own residents, as those of Greece. Why? Because much of the money spent in California comes from Washington, not Sacramento. State funding may be slashed, but Medicare reimbursements, Social Security checks, and payments to defense contractors will keep on coming.

What this means, among other things, is that California’s budget woes won’t keep the state from sharing in a broader U.S. economic recovery. Greece’s budget cuts, on the other hand, will have a strong depressing effect on an already depressed economy.

So is a debt restructuring — a polite term for partial default — the answer? It wouldn’t help nearly as much as many people imagine, because interest payments only account for part of Greece’s budget deficit. Even if it completely stopped servicing its debt, the Greek government wouldn’t free up enough money to avoid savage budget cuts.

The only thing that could seriously reduce Greek pain would be an economic recovery, which would both generate higher revenues, reducing the need for spending cuts, and create jobs. If Greece had its own currency, it could try to engineer such a recovery by devaluing that currency, increasing its export competitiveness. But Greece is on the euro.

So how does this end? Logically, I see three ways Greece could stay on the euro.

First, Greek workers could redeem themselves through suffering, accepting large wage cuts that make Greece competitive enough to add jobs again. Second, the European Central Bank could engage in much more expansionary policy, among other things buying lots of government debt, and accepting — indeed welcoming — the resulting inflation; this would make adjustment in Greece and other troubled euro-zone nations much easier. Or third, Berlin could become to Athens what Washington is to Sacramento — that is, fiscally stronger European governments could offer their weaker neighbors enough aid to make the crisis bearable.

The trouble, of course, is that none of these alternatives seem politically plausible.

What remains seems unthinkable: Greece leaving the euro. But when you’ve ruled out everything else, that’s what’s left.

If it happens, it will play something like Argentina in 2001, which had a supposedly permanent, unbreakable peg to the dollar. Ending that peg was considered unthinkable for the same reasons leaving the euro seems impossible: even suggesting the possibility would risk crippling bank runs. But the bank runs happened anyway, and the Argentine government imposed emergency restrictions on withdrawals. This left the door open for devaluation, and Argentina eventually walked through that door.

If something like that happens in Greece, it will send shock waves through Europe, possibly triggering crises in other countries. But unless European leaders are able and willing to act far more boldly than anything we’ve seen so far, that’s where this is heading.

Thursday, May 6, 2010

Europe: Time for Plan B

Europe is heading into the abyss. 

The EUR 110B Greek rescue package is a bridge loan that keeps Greece out of the capital market for only 18 months, and then assumes that all will be well. 

At the end of 2011, when the bailout runs out, Greece will have higher debt and a a smaller GDP. A country with an unsustainable debt load will be unable to issue debt at reasonable spreads. 

This is obvious to all observers, which is why the bailout lacks credibility. And as investors lose confidence, they will fly to quality and abandon the rest of the PIGS (or PIIGS, because Ireland looks awful). 

What are the options for the peripheral members? I see three:
  • Rescheduling (default).
  • Rescue by the ECB.
  • Redenomination, devaluation and inflation.

Rescheduling means loss of market access and a massive fiscal consolidation: a nonstarter. An ECB rescue has been vetoed by the  Teutonic bloc and "has not been discussed". Germany doesn't want its currency backed by Mediterranean junk bonds.

I had been under the impression that a unilateral redenomination of government bonds would be treated legally as default. However, Vincent Truglia (former head of Moody's sovereign risk unit) thinks otherwise. He says that (1) redenomination was not default when the euro was adopted; and (2) the election of law on Greek governments is Greek, which is to say debtor-friendly (no default). 

So Vincent argues that the peripherals should immediately redenominate, devalue and inflate. I agree. The open question is whether to continue to service external debt or to do an Argentina and give foreigners a haircut. Vincent says that devaluation will accomplish this without a legal default.

The price of quitting the euro is the risk of being kicked out of the EU, but there is no legal mechanism to expel a member. But you have to ask: is Greece European or Near Eastern? It was part of the Ottoman Empire for centuries. It sure is no Finland. As my Spanish colleague used to say, "It is not a serious country".

The problem here is that there is little public consideration being given to redenomination and resurrection of the drachma. Instead, Europe and Papandreou are wedded to the austerity/rescue plan, which will lead to an even bigger train wreck. 

Oh, and by the way, the Bundestag has not yet voted for the rescue and it's not in the bag. That would lead directly to Plan B.